Unfairly Defiled: A Long Term Perspective on Portfolio Insurance as a Strategy for Limiting Portfolio Losses

Jeffrey Ludwig

doi:doi:10.11648/j.jim.20211002.12

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Unfairly Defiled: A Long Term Perspective on Portfolio Insurance as a Strategy for Limiting Portfolio Losses

Jeffrey Ludwig

Published in Journal of Investment and Management (Volume 10, Issue 2)

Received: 4 June 2021 Accepted: 24 June 2021 Published: 13 July 2021

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Abstract

The invention of portfolio insurance as a strategy for limiting portfolio losses was introduced in the early 1980s and gained spectacular popularity throughout the decade, attracting between $60 billion to $90 billion from institutional money managers. The method provided downside protection against a long equity position by synthetically replicating a long put option using equity futures during an era when exchange-traded equity options were not sufficiently liquid. Unfortunately, the strategy came to a catastrophic end on the “Black Monday” of October 19, 1987, when the president of the New York Stock Exchange shut down the nascent technology used by index arbitrage program trading groups. This caused significant mispricings between futures and cash markets, making the required synthetic put option replication trading impossible. The portfolio insurance strategy was declared a complete failure and never has since regained widespread popularity. Three decades later, modern markets now fully embrace program trading, and the likelihood that program trading would be shut down for any reason ever again seems impossible. This paper examines how portfolio insurance would have performed during the 1991 to 2020 time period, during which 3 major stock market crashes occurred and program trading was never shut down. The paper concludes that portfolio insurance received unjust blame for the 1987 crash and its abandonment since then has been irrational and unfortunate for those seeking long equity exposure with a cost-efficient strategy for limiting portfolio losses.

Published in	Journal of Investment and Management (Volume 10, Issue 2)
DOI	10.11648/j.jim.20211002.12
Page(s)	30-37
Creative Commons	This is an Open Access article, distributed under the terms of the Creative Commons Attribution 4.0 International License (http://creativecommons.org/licenses/by/4.0/), which permits unrestricted use, distribution and reproduction in any medium or format, provided the original work is properly cited.
Copyright	Copyright © The Author(s), 2024. Published by Science Publishing Group

Keywords

Portfolio Insurance, Synthetic Options, Risk Management

References

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[3]	Katsikis, Vasilios N. and Mourtas, Spyridon D. Portfolio Insurance and Intelligent Algorithms, pp. 305-323, in Computational Management: Applications of Computational Intelligence in Business Management. Springer International Publishing, 2021. https://doi.org/10.1007/978-3-030-72929-5 14
[4]	Medvedeva, MA, Katsikis, VN, Mourtas, SD, Simos, TE. Randomized time-varying knapsack problems via binary beetle antennae search algorithm: Emphasis on applications in portfolio insurance. Math Meth Appl Sci. 2021; 44: 2002-2012. https://doi.org/10.1002/mma.6904
[5]	Katsikis, Vasilios N. and Mourtas, Spyridon D. Binary Beetle Antennae Search Algorithm for Tangency Portfolio Diversification. Journal of Modeling and Optimization. Vol 13 No 1, 2021. https://doi.org/10.32732/jmo.2021.13.1.44
[6]	Ruehl, Thorsten. Quant Models for Robo-Advisors. Robo-Advisory: Investing in the Digital Age, pp 71-92. 2021. https://doi.org/10.1007/978-3-030-40818-3 5
[7]	Alan, Nazli Sila and Mahoney, Timothy and Schwartz, Robert A. Invited Editorial: Combatting Turbulence in the Equity Market-Get the Listed Companies on Board in Equity Trading Round-Up: Proposals for Strengthening the Markets. Springer International Publishing, 2021. https://doi.org/10.1007/978-3-030-51015-2 10
[8]	Henriques, D. B. A First-Class Catastrophe: The Road to Black Monday, the Worst Day in Wall Street History. Henry Holt and Co.; 1st Edition (September 19, 2017). https://us.macmillan.com/books/9781627791649
[9]	Leland, H. Option Pricing and Replication With Transaction Costs. January 1985. The Journal of Finance 40 (5): 1283-1301 https://doi.org/10.1111/j.1540- 6261.1985.tb02383.x
[10]	Hull, J. C. Options, Futures and Other Derivatives, fourth edition, 2000. Upper Saddle River, Prentice Hall, New Jersey.
[11]	Black, F., & Scholes, M. The Pricing of Options and Corporate Liabilities. The Journal of Political Economy, 81 (3) (May - Jun., 1973), pp. 637-654. http://dx.doi.org/10.1086/260062
[12]	Cox, J. C, Ross, S. A., and Rubinstein, M. Option pricing: A simplified approach. Journal of Financial Economics, 7 (3), September 1979. pp. 229-63. https://doi.org/10.1016/0304-405X(79)90015-1
[13]	Merton, R. C. Theory of Rational Option Pricing. The Bell Journal of Economics and Management Science, 4 (1), pp. 141 to 183. https://doi.org/10.2307/3003143
[14]	Black, F. How we came up with the option formula. Journal of Portfolio Management, 1989, 15 (2), pp. 4-8.
[15]	Bernstein, P. L. 1992. Capital Ideas, The Improbable Origins of Modern Wall Street, New York, London, Toronto, Sydney, Tokyo, Singapore. The Free Press.
[16]	Kiyosi Ito. Stochastic Integral. Proceedings of The Imperial Academy, October 12, 1944. Tokyo 20 (8), pp. 519 to 524. https:/doi.org/10.3792/pia/1195572786

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APA Style

Jeffrey Ludwig. (2021). Unfairly Defiled: A Long Term Perspective on Portfolio Insurance as a Strategy for Limiting Portfolio Losses. Journal of Investment and Management, 10(2), 30-37. https://doi.org/10.11648/j.jim.20211002.12

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Jeffrey Ludwig. Unfairly Defiled: A Long Term Perspective on Portfolio Insurance as a Strategy for Limiting Portfolio Losses. J. Invest. Manag. 2021, 10(2), 30-37. doi: 10.11648/j.jim.20211002.12

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AMA Style

Jeffrey Ludwig. Unfairly Defiled: A Long Term Perspective on Portfolio Insurance as a Strategy for Limiting Portfolio Losses. J Invest Manag. 2021;10(2):30-37. doi: 10.11648/j.jim.20211002.12

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@article{10.11648/j.jim.20211002.12,
  author = {Jeffrey Ludwig},
  title = {Unfairly Defiled: A Long Term Perspective on Portfolio Insurance as a Strategy for Limiting Portfolio Losses},
  journal = {Journal of Investment and Management},
  volume = {10},
  number = {2},
  pages = {30-37},
  doi = {10.11648/j.jim.20211002.12},
  url = {https://doi.org/10.11648/j.jim.20211002.12},
  eprint = {https://article.sciencepublishinggroup.com/pdf/10.11648.j.jim.20211002.12},
  abstract = {The invention of portfolio insurance as a strategy for limiting portfolio losses was introduced in the early 1980s and gained spectacular popularity throughout the decade, attracting between $60 billion to $90 billion from institutional money managers. The method provided downside protection against a long equity position by synthetically replicating a long put option using equity futures during an era when exchange-traded equity options were not sufficiently liquid. Unfortunately, the strategy came to a catastrophic end on the “Black Monday” of October 19, 1987, when the president of the New York Stock Exchange shut down the nascent technology used by index arbitrage program trading groups. This caused significant mispricings between futures and cash markets, making the required synthetic put option replication trading impossible. The portfolio insurance strategy was declared a complete failure and never has since regained widespread popularity. Three decades later, modern markets now fully embrace program trading, and the likelihood that program trading would be shut down for any reason ever again seems impossible. This paper examines how portfolio insurance would have performed during the 1991 to 2020 time period, during which 3 major stock market crashes occurred and program trading was never shut down. The paper concludes that portfolio insurance received unjust blame for the 1987 crash and its abandonment since then has been irrational and unfortunate for those seeking long equity exposure with a cost-efficient strategy for limiting portfolio losses.},
 year = {2021}
}

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TY  - JOUR
T1  - Unfairly Defiled: A Long Term Perspective on Portfolio Insurance as a Strategy for Limiting Portfolio Losses
AU  - Jeffrey Ludwig
Y1  - 2021/07/13
PY  - 2021
N1  - https://doi.org/10.11648/j.jim.20211002.12
DO  - 10.11648/j.jim.20211002.12
T2  - Journal of Investment and Management
JF  - Journal of Investment and Management
JO  - Journal of Investment and Management
SP  - 30
EP  - 37
PB  - Science Publishing Group
SN  - 2328-7721
UR  - https://doi.org/10.11648/j.jim.20211002.12
AB  - The invention of portfolio insurance as a strategy for limiting portfolio losses was introduced in the early 1980s and gained spectacular popularity throughout the decade, attracting between $60 billion to $90 billion from institutional money managers. The method provided downside protection against a long equity position by synthetically replicating a long put option using equity futures during an era when exchange-traded equity options were not sufficiently liquid. Unfortunately, the strategy came to a catastrophic end on the “Black Monday” of October 19, 1987, when the president of the New York Stock Exchange shut down the nascent technology used by index arbitrage program trading groups. This caused significant mispricings between futures and cash markets, making the required synthetic put option replication trading impossible. The portfolio insurance strategy was declared a complete failure and never has since regained widespread popularity. Three decades later, modern markets now fully embrace program trading, and the likelihood that program trading would be shut down for any reason ever again seems impossible. This paper examines how portfolio insurance would have performed during the 1991 to 2020 time period, during which 3 major stock market crashes occurred and program trading was never shut down. The paper concludes that portfolio insurance received unjust blame for the 1987 crash and its abandonment since then has been irrational and unfortunate for those seeking long equity exposure with a cost-efficient strategy for limiting portfolio losses.
VL  - 10
IS  - 2
ER  -

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Author Information

Jeffrey Ludwig

Department of Mathematics, University of California, Irvine, United States of America

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Plain Text BibTeX RIS

APA Style

Jeffrey Ludwig. (2021). Unfairly Defiled: A Long Term Perspective on Portfolio Insurance as a Strategy for Limiting Portfolio Losses. Journal of Investment and Management, 10(2), 30-37. https://doi.org/10.11648/j.jim.20211002.12

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ACS Style

Jeffrey Ludwig. Unfairly Defiled: A Long Term Perspective on Portfolio Insurance as a Strategy for Limiting Portfolio Losses. J. Invest. Manag. 2021, 10(2), 30-37. doi: 10.11648/j.jim.20211002.12

Copy | Download

AMA Style

Jeffrey Ludwig. Unfairly Defiled: A Long Term Perspective on Portfolio Insurance as a Strategy for Limiting Portfolio Losses. J Invest Manag. 2021;10(2):30-37. doi: 10.11648/j.jim.20211002.12

Copy | Download

@article{10.11648/j.jim.20211002.12,
  author = {Jeffrey Ludwig},
  title = {Unfairly Defiled: A Long Term Perspective on Portfolio Insurance as a Strategy for Limiting Portfolio Losses},
  journal = {Journal of Investment and Management},
  volume = {10},
  number = {2},
  pages = {30-37},
  doi = {10.11648/j.jim.20211002.12},
  url = {https://doi.org/10.11648/j.jim.20211002.12},
  eprint = {https://article.sciencepublishinggroup.com/pdf/10.11648.j.jim.20211002.12},
  abstract = {The invention of portfolio insurance as a strategy for limiting portfolio losses was introduced in the early 1980s and gained spectacular popularity throughout the decade, attracting between $60 billion to $90 billion from institutional money managers. The method provided downside protection against a long equity position by synthetically replicating a long put option using equity futures during an era when exchange-traded equity options were not sufficiently liquid. Unfortunately, the strategy came to a catastrophic end on the “Black Monday” of October 19, 1987, when the president of the New York Stock Exchange shut down the nascent technology used by index arbitrage program trading groups. This caused significant mispricings between futures and cash markets, making the required synthetic put option replication trading impossible. The portfolio insurance strategy was declared a complete failure and never has since regained widespread popularity. Three decades later, modern markets now fully embrace program trading, and the likelihood that program trading would be shut down for any reason ever again seems impossible. This paper examines how portfolio insurance would have performed during the 1991 to 2020 time period, during which 3 major stock market crashes occurred and program trading was never shut down. The paper concludes that portfolio insurance received unjust blame for the 1987 crash and its abandonment since then has been irrational and unfortunate for those seeking long equity exposure with a cost-efficient strategy for limiting portfolio losses.},
 year = {2021}
}

Copy | Download

TY  - JOUR
T1  - Unfairly Defiled: A Long Term Perspective on Portfolio Insurance as a Strategy for Limiting Portfolio Losses
AU  - Jeffrey Ludwig
Y1  - 2021/07/13
PY  - 2021
N1  - https://doi.org/10.11648/j.jim.20211002.12
DO  - 10.11648/j.jim.20211002.12
T2  - Journal of Investment and Management
JF  - Journal of Investment and Management
JO  - Journal of Investment and Management
SP  - 30
EP  - 37
PB  - Science Publishing Group
SN  - 2328-7721
UR  - https://doi.org/10.11648/j.jim.20211002.12
AB  - The invention of portfolio insurance as a strategy for limiting portfolio losses was introduced in the early 1980s and gained spectacular popularity throughout the decade, attracting between $60 billion to $90 billion from institutional money managers. The method provided downside protection against a long equity position by synthetically replicating a long put option using equity futures during an era when exchange-traded equity options were not sufficiently liquid. Unfortunately, the strategy came to a catastrophic end on the “Black Monday” of October 19, 1987, when the president of the New York Stock Exchange shut down the nascent technology used by index arbitrage program trading groups. This caused significant mispricings between futures and cash markets, making the required synthetic put option replication trading impossible. The portfolio insurance strategy was declared a complete failure and never has since regained widespread popularity. Three decades later, modern markets now fully embrace program trading, and the likelihood that program trading would be shut down for any reason ever again seems impossible. This paper examines how portfolio insurance would have performed during the 1991 to 2020 time period, during which 3 major stock market crashes occurred and program trading was never shut down. The paper concludes that portfolio insurance received unjust blame for the 1987 crash and its abandonment since then has been irrational and unfortunate for those seeking long equity exposure with a cost-efficient strategy for limiting portfolio losses.
VL  - 10
IS  - 2
ER  -

Copy | Download